Why prices rise

There is another way to say what inflation is. If the price of nearly everything rises, then each pound, dollar or dirham buys less than it used to. What one unit of money can buy is its purchasing power, and inflation is that purchasing power falling.

Even gentle inflation adds up, because each year's rise lands on top of the last. At 2 per cent a year, prices double in about 35 years, so money kept in a drawer for that long buys only half as much. At 7 per cent, they double in about 10 years. This is why a price from your childhood can sound absurdly cheap. The bread hasn't changed; the money that pays for it has.

How do you measure a rise in nearly every price at once? Statisticians fill an imaginary shopping basket with the goods and services a typical household buys, then price the same basket again and again. In Britain the Office for National Statistics keeps about 760 items in it, from bread, tea and petrol to rent, pet grooming and hotel stays. Collectors and shops' till data track the same products in the same shops each month, so the only thing that changes is the price.

The basket's cost is turned into a price index, set at 100 in a chosen base year. If the index reads 100 one year and 103 the next, the basket costs 3 per cent more, and that is the inflation rate. The basket itself is refreshed every year: in 2026 houmous and dashboard cameras went in, and wrapping paper sheets gave way to rolls.

A basket is not a simple list, because households don't spend equally on everything. If petrol and tea both rose by 10 per cent, the petrol rise would hurt far more, since far more of a typical budget goes on fuel than on tea. So each item's price change counts in proportion to its share of household spending, called its weight, and the index is a weighted average of all the changes.

In the British index that also counts homeowners' costs, housing for 2026, meaning rent, homeowners' costs and energy and water bills, carries about 31 per cent of the weight and food about 9. That is also why your own inflation can differ from the official figure. A household that drives a lot feels dearer fuel more than the average does, and one that rents feels rent rises more.

Now to the causes, starting with the oldest explanation. Imagine an island whose people hold 1,000 coins between them and bake 1,000 loaves a year. If the ruler mints another 1,000 coins but nobody bakes more bread, there is twice as much money chasing the same loaves, and bakers can ask about twice the price. Printing creates more money, not more goods, so a government cannot make everyone richer this way. Prices rise until the extra money buys only what the old money did.

This link between the amount of money and the level of prices is the quantity theory of money. Milton Friedman put it bluntly in 1963: inflation is "always and everywhere a monetary phenomenon". Economists still argue over how far that holds. A study of about 160 countries found the link strong where inflation ran high, and weak where it stayed low.

Blaming too much money is far older than Friedman. In 1403 the Nile flood failed in Egypt, then ruled by the Mamluk sultans; plague followed, and grain grew painfully dear. In 1405 the Cairo historian al-Maqrīzī, who had once served as the city's market inspector, wrote a treatise, Ighāthat al-umma, arguing that the worst of the crisis was man-made.

Past dearths, he wrote, had come from nature; this one came from misrule. He named three causes: offices bought with bribes, land rents that had risen tenfold, and above all the rulers' flood of copper coins, called fulūs, while silver coins had all but stopped being minted. Cheapening a currency like this, by filling it with coins of less valuable metal, is debasement, and to al-Maqrīzī it was the main reason prices had soared.

A second cause starts with buyers. The Damascus jurist Ibn Taymiyya, who died in 1328, observed that a price can rise without anyone doing wrong: when desire for a good grows while its supply shrinks, its price goes up of its own accord.

Now picture desire growing for most goods at once, faster than the economy can make them. When households, businesses and government together try to buy more than the economy can produce, factories are already running flat out and there are few idle workers left to hire. Shops sell out, builders have waiting lists, and sellers find they can charge more without losing customers. This is demand-pull inflation: spending pulls prices up because output cannot rise to meet it. It tends to come in booms, when borrowing and spending are surging.

Prices can also be pushed up from the other side, by the cost of making things. In the oil crisis that began in October 1973, the price of a barrel of crude oil nearly quadrupled in three months, from $2.90 to $11.65. Oil drives lorries, ships and power stations and goes into plastics and fertiliser, so nearly every business faced higher costs at once, and most passed them on.

A sudden jump in costs like this is a supply shock, and the inflation it causes is called cost-push. It is especially painful because output tends to fall while prices rise. Britain met a similar shock in 2022, when soaring gas and electricity bills made the biggest contribution to its 11.1 per cent inflation.

Once inflation has run for a while, people plan around it, and the planning keeps it going. If workers expect prices to rise 10 per cent next year, they ask for 10 per cent more pay just to stand still. Firms that expect their wages and supplies to cost more raise their own prices in advance. So wages rise, costs rise, and prices rise again, each rise seeming to justify the next. This loop is a wage-price spiral, and it is why central banks watch what people expect.

In the United States in the 1970s, rising prices came to be expected and built into plans, and inflation passed 14 per cent in 1980. Its grip is debated, though. An IMF study of rich economies since the 1960s found that most bursts of rising wages and prices settled down rather than spiralling.

Inflation doesn't hit everyone equally, because it shrinks whatever is fixed in money. Savings in a jar lose value every year, and so does a pension or a salary that stays the same while prices climb. Al-Maqrīzī saw this in 1405: Cairo's jurists and scholars, living on fixed stipends, were hard hit, while craftsmen and wage earners, scarce after the plague, did better as their pay rose.

The same arithmetic runs the other way for debts. Someone who borrowed a fixed sum repays the same number of pounds, but each pound buys less by then. The real value of the debt, what the money could actually buy, has shrunk. So borrowers of fixed sums gain from inflation and lenders lose. A debt that looked heavy can feel far lighter a decade later, once wages and prices have risen around it and the sum owed has not.

At its extreme, inflation destroys a currency. In 1914 a US dollar cost 4.2 German marks. After the First World War, Germany's government kept printing money to pay its bills, and in 1923, when French and Belgian troops occupied the Ruhr and German workers there stopped work, it paid them with a flood of new banknotes. By November 1923 a dollar cost 4.2 trillion marks, and a loaf of bread in Berlin that had cost about 160 marks at the end of 1922 cost around 200 billion.

Economists call this hyperinflation, usually defined as prices rising by more than 50 per cent in a single month. People spend money the moment they get it, before it loses more value. Historians still argue over how much the war reparations Germany owed were to blame.

Most countries hand the job of holding inflation down to a central bank, such as the Bank of England or the US Federal Reserve. Its main lever is a benchmark interest rate that it sets, which feeds through to what banks charge on loans and mortgages and pay on savings. Islam forbids ribā, interest on a loan, and Islamic banks are designed to work without it, but most of the world's central banks steer by this rate.

To cool inflation, a central bank raises its rate. Borrowing becomes dearer and saving more rewarding, so households and businesses spend less. With customers cutting back, firms find it harder to raise prices, and inflation slows. The effect is slow, often taking up to two years, so a central bank must act on where it thinks inflation is heading, not just where it is now.

If inflation does such harm, why don't central banks aim for none? In 1990 New Zealand became the first country to give its central bank an inflation target, 0 to 2 per cent. Today most rich countries aim for about 2 per cent a year, and there are reasons to stop short of zero.

Falling prices, called deflation, can be worse than rising ones. If people expect things to be cheaper next month, some put off buying, businesses sell less, and jobs are lost. Fixed debts grow heavier too. A little inflation also leaves room to cut interest rates in a slump, since rates can't go far below zero. Still, 2 per cent is a judgement, not a law. In 2010 economists at the IMF asked whether 4 per cent might be safer, while in 2007 one Federal Reserve policymaker had argued for 1.